Tuesday, May 12, 2009

How much prudential regulation do we need?

It was a few weeks since I had seen Jim, so I made the mistake of asking him what he had been doing. He replied that he had been thinking about bankruptcy.

I said that I didn’t know his financial situation was that bad. Jim replied that he wasn’t having too much trouble paying his own bills at this stage, but he had been thinking about bankruptcy as an institution and about the role of government in bankruptcy. While he was saying that I was thinking that Jim was not the kind of person who would ever have too much trouble paying his bills. I heard him ask: “What do you think about bankruptcy?”

I said that I thought modern bankruptcy laws that wiped the slate clean when debtors had no hope of meeting their obligations were a huge advance on traditional practices such as virtual enslavement or imprisonment of people who could not pay their debts. I added that in my view there had to be a role for government in this process because you can’t allow people to hire muscle to pressure people to pay their debts. Since we have to rely ultimately on the coercive power of government to enforce contracts then we have to rely on government to devise rules about the conditions under which contracts cannot be enforced.

Jim nodded. He then asked: “What do you think about limited liability?” I said that I thought the contribution of limited liability to economic growth was often overstated because liability insurance could have arisen to serve a similar purpose in enabling individual investors to limit their liability when in investing in companies. I added, however, that I couldn’t see a problem in the owners of a firm declaring that their liability was limited to the amounts they had invested. In my view transparency is the important issue: people who lend money to the firm or provide good on credit should be aware that if the firm goes bust the liability of the owners is limited.

Jim said: “Hmm, so you are saying that if I form a company to engage in speculation there should be no limit on the amount of debt that the company can incur? Are you saying that I should be allowed to gamble with other people’s money secure in the knowledge that if the gamble doesn’t pay off then my own liability is limited to the extent of my own investment in the company?” I insisted that transparency was the important issue. If people are prepared to take the risks involved in lending money to speculators, good luck to them.

Jim said: “People who take those risks need all the luck they can get. What about systemic risks? It is one thing to accept that a few people will lose their life savings whenever some highly leveraged property speculator goes bust, but isn’t it something quite different when confidence in the whole financial system is threatened because of excessive leverage in major financial institutions?” I did my best to put the argument that the current financial crisis arose at the end of last year because central banks in major economies hadn’t established a credible commitment to maintaining a stable rate of nominal GDP growth. I suggested that the best way to deal with the deleveraging and associated decline in the velocity of circulation would have been by maintaining a monetary policy that would promote expectations of a stable rate of growth in nominal GDP.

I could see Jim’s eyes glaze over as I spoke. He said: “If you were making government policy decisions in the aftermath of the current financial crisis wouldn’t you be looking to see what could be done to avoid re-emergence of systemic risk in major financial institutions? I had to admit that if I was making government policy decisions I would probably be looking for policy levers relating to capital adequacy and things like that.

Jim said: “Ah, you sound just like one of those neo-socialists who advocates more financial regulation in order to save the capitalist system. Rather than interfering in the financial management of healthy companies, wouldn’t it be better for governments to focus on improving laws to minimize the adverse effects on the wider economy that can occur when some companies become insolvent. For example, why can’t the ownership of insolvent companies be quickly transferred to creditors?”

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